US debt-limit talks descend into acrimony

Now that Greece has been temporarily ‘saved’, the focus might start to shift to the unresolved and equally serious issue of the US debt limit. Unfortunately, the omens on this front still look gloomy, with President Obama yesterday chastising the Republicans for their lack of concern for children and the elderly in their negotiations over the deficit. The Democrats want tax increases to form part of the package to reduce America’s fiscal largesse, whereas the GOP is after meaningful cuts in entitlements and in Medicare payments to the elderly. The Republicans continue to argue that a bill which both lifts the debt ceiling and raises taxes will not pass through Congress.

Most alarming is the position of a number of new Congressmen aligned to the Tea Party movement who have dismissed the urgency of raising the debt ceiling by August 2nd. Two days ago, a senior Republican who participated in the bipartisan deficit negotiations with Vice-President Biden stated that it was increasingly likely that Republicans in the House will not act to raise the debt limit by the August 2nd deadline unless the Democrats agree to major changes in entitlements.

The more alarming language being used by Republicans this week has certainly unnerved both the dollar and treasury yields – for instance, the 10-yr yield has jumped 25bp from the lows recorded late last week.

After the ecstasy, the cold light of day. As with the confidence vote last week, the price action ahead of the Greek Parliamentary vote on the austerity package largely anticipated a positive outcome, the euro already one of the strongest of the major currencies so far this week. The relief has continued overnight, with the single currency pressing on through 1.45. However, as with all the hurdles passed in the euro sovereign debt crisis over the past year and especially recently, it very much feels like a hollow victory. Greece has voted to enact more austerity which, in all likelihood, will continue to crush the economy whilst the debt burden continues to rise. Furthermore, although this was a binary outcome (either acceptance or failure), the result of the current negotiations around a voluntary rollover of Greek debt will be far less clear-cut in terms of its ability to tackle head-on the issue of debt sustainability and, by design, the ability of Greece to avoid the full-scale debt restructuring wherein hair-cuts are taken on outstanding debt. Furthermore, and potentially far more divisive will be the verdict of the ratings agencies and ISDA on the proposal that is currently taking shape. The next hurdle for markets is the meeting of finance ministers of the eurozone who will hammer out the details of a new bailout package and the extent and form of private sector involvement. The IMF has made the next payment tranche of the current aid package conditional on an agreement being reached on this new bailout. At present, the proposal on voluntary debt restructuring does not appear to be the panacea that many are after, not least because it’s a rollover that reduces the interest burden but does not impose a hair-cut on the outstanding debt. The single currency has shown remarkable resilience this week, but it may have only so much resolve left.

Risk appetite improves further on Greek ‘Yes’ vote. Both commodities and equities received a further boost from the anticipation and subsequent confirmation that the Greek parliament approved the austerity package. Brent crude, which fell to near $102 on Monday, traded through $112 overnight with last week’s announcement that the IEA would release 60m barrels of crude from their reserves already a distant memory. The major European bourses rose by more than 1.5% yesterday, with similar increases in Asia overnight. In currencies, the dollar and the Swiss franc retreated slightly, while high-beta currencies such as the Aussie continued to find friends. The latter has been especially buoyant – earlier this week it was looking decidedly vulnerable after penetrating 1.04, but there has been constant buying support since then and overnight it has reached 1.0750. Both the Aussie and the Kiwi have benefitted from end-of-financial year demand, as well as flows related to participation in toshin issues. Indeed, the Kiwi reached a 30yr high against the dollar overnight.

The UK’s worsening inflation problem. After a while, consumers start to believe that higher inflation is the norm. According to the latest survey conducted by YouGov/Citigroup, UK year-ahead inflation expectations jumped to 3.9% this month from 3.4% in May. At the same time, longer-term inflation expectations soared to 4.1%, from 3.5% previously. The MPC ought to be very concerned about these latest developments. That said, with the private sector still very firmly in recession, it would be complete lunacy to suggest it should hike rates. Consumer confidence remains very depressed, as confirmed overnight by the latest GfK survey.

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